While it may be anticlimactic, we've taken our first spoonful of medicine. Federal Reserve Chairwoman Janet Yellen got it right when she hiked the benchmark federal fund’s interest rate 0.25 percent yesterday.
The Federal Reserve's plan to raise interest rates has seemingly been one long drum roll. Speculation about when the hikes would begin, and how big they would be, has been going on for months. The increase marks a turning point, with the Fed finally believing the U.S. economy is gathering steam.
With the U.S. economy on more solid ground, the Fed signaled in yesterday’s move that it can now begin a slow series of rate increases to head off any future inflation.
One of the Fed's key priorities is to rein in inflation, and Yellen expects inflation to rise over the next couple of years to the Fed's target level of about 2 percent. By raising rates and making it more expensive to borrow, the Fed hopes to dampen spending a tad, making it harder for inflation to get a foothold. As the Fed moves forward, the expectation is it may choose to forgo increases at some meetings as it watches how the economy reacts to each move.
How will a measured pace of rate hikes affect stocks and bonds?
When the Fed practices moderation with its rate-hiking approach — as it should do now — stocks on average in the S&P 500 trended upwards one year later.
In past cycles of rising interest rates, the U.S. dollar remained strong for five to six months after the first rate increase. This suggests that domestic equities may temporarily outperform international stocks as markets sort out the impact.
While most other world economies still are applying stimulus, the United States will tap the brakes heading into 2016 to keep its momentum at a steady, manageable speed.
Scott Colbert is chief economist and director of fixed income for Commerce Trust Co. He can be reached at contact@commercebank.com.
